“There Is Regulatory Capture, But It Is By No Means Complete”

Kenneth J. Arrow, one of the most influential economists of the 20th century, reflects on the benefits of a single payer health care system, the role of government and regulatory capture.

Kenneth Arrow (Photo by Jamie Rector/Bloomberg via Getty Images)

Kenneth J. Arrow requires very little introduction. Very few people, if any, can say they have influenced the development of economic theory in the 20th century as deeply as Arrow, who revolutionized the field of economics with groundbreaking contributions to general equilibrium theory, welfare theory, social choice theory and risk. In 1972, at the age of 51, Arrow won the Nobel Prize in Economics (sharing the prize with John R. Hicks). Arrow was the youngest economist ever to win the prize, a title he still holds to this day.

An emeritus professor of economics and operations research at Stanford, Arrow has been at the forefront of economic theory since 1951, when his Ph.D. dissertation (and subsequent formative book, Social Choice and Individual Values) effectively formed the basis for social choice theory. Arrow’s impossibility theorem — which roughly states that no voting system can properly aggregate and reflect social preferences without violating at least one of several reasonable requirements for fairness — inspired countless studies on collective decision-making in the 60-plus years since it was first published, and greatly influenced welfare economics.

Along with Gérard Debreu, Arrow created the Arrow–Debreu model, that proved that under certain conditions markets can indeed reach general equilibrium – that is, an optimal allocation of resources. This monumental feat essentially solved a problem neoclassical economists have been trying to solve for more than 70 years, ever since Léon Walras first developed the general equilibrium theory in 1874, which stated that a set of prices able to balance all supply and demand does in fact exist. Based on ingenious mathematics, Arrow’s and Debreu’s model proved to be a pillar of modern economic thought, but was later criticized for being based on unrealistic assumptions. Arrow himself has embraced many of the criticisms made against the general equilibrium theory, calling it “empirically falsified.” Over the years he has made further contributions to the theory, incorporating into it such elements as uncertainty and allocation of risk for the first time.

Born in New York in 1921, the son of Romanian-Jewish immigrants, Arrow’s life and work were profoundly influenced by the experience of growing up during the Great Depression. Over the years, his published papers on a wide variety of subjects, from innovation and monopolies to racial discrimination, information and climate change. In 1963, he published his classic paper on health care, Uncertainty and the Welfare Economics of Health Care, which was the first to show that existing competitive market models cannot be applied to the health care industry. The article effectively created the field of health economics, and is still frequently cited in debates regarding the role of non-market forces and institutions (like government) in the health system.

Arrow is as influential as a teacher as he is as a theorist: five of his former students, among them Joseph E. Stiglitz and Eric Maskin, have went on to win Nobel prizes of their own.

At the age of 94, Arrow is as sharp as ever. In a phone interview with ProMarket, he reflects on the ways American health care changed in the past five decades, the role of government in health care, and the issues of rent-seeking and regulatory capture.

Q: looking back on your seminal 1963 paper about healthcare industry – it seems that the American health care system has only gotten worse since. Some people claim that it is the worst among developed nations in terms of cost, waste and wrong incentives to physicians, hospitals and research, and influence of special interest groups – producing very high rents, and little value.

Certainly in terms of inefficiency, I don’t think it has improved at all. The system is about as inefficient, and it was pretty inefficient then too. If we look at measurements like cost per capita, compared to comparable countries like Canada or the U.K., it got worse. The rather reasonable attempts to improve the delivery, that is to extend health care to more people, have led to a bigger system, and therefore more complexity and more chance for exploitation. We talk about a price system, but that is not what we have. What we have is a system in which one buyer will pay ten times what other buyers will pay for similar medical devices, or services. So the idea of a price system as the source of efficiency fails at the most elementary level.

The same is true, to a somewhat lesser extent, about pharmaceuticals, where the price also varies. Drug prices in the United States are considerably higher than they are anywhere else, and that is easier to explain: in other countries the buyer is a monopsonist. The government is at least a dominant buyer in most countries, that is a way of keeping the prices down. In the United States, Medicare is forbidden by law to bargain with pharmaceuticals.

These things are never simple. You do want incentives for pharmaceutical companies to generate new drugs. Developing drugs is a pretty expensive proposition, and the failure rate is pretty high, so we have to create incentives for companies to innovate. The problem with what’s happening now is that to some extent, because the American market is not uncontrolled and other markets are, we are subsidizing new drugs to other countries.

Q: Is there a way to mitigate this problem?

This is not a problem that’s just confined to the pharmaceutical industry, but I think it’s most intense there. The question of intellectual property goes back several hundred years. Since the 17th century, the basic deal is that in return for the innovation, you give [innovators] monopoly power. That’s the way you pay for the upfront costs and provide incentive. This of course gives rise to monopolies, which is an inevitable conflict. Even Hayek was disturbed about whether intellectual property is really property in the same sense that a house is property.

The truth is it’s very easy to rail against it, but it’s not easy to find a substitute. People have proposed substitutes from time to time, like paying the innovator the social value of the innovation, and insist on free competition after that. But since no one knows how to evaluate the social value, it’s not a very practical answer.

There is no easy way out of this conflict, though a better-regulated system could help. A better bargaining position will improve matters, but you have to be a little careful, because you don’t want to hurt innovation. What you have under the present situation is a great incentive for health providers, hospitals and HMO, to get bigger, because that improves their bargaining position vis-à-vis the insurance companies.

A single payer will have control that will allow it to prevent things like differential pricing from happening. If the government was allowed to use its bargaining power, it would dominate. There will be monopolies, but they would be facing a single payer. A monopoly usually has power because it is the only one facing a large market of diverse individuals.

I’m afraid you’re talking to someone who’s an “on the one hand, on the other hand” type of person, which makes me a poor advocate.

I wouldn’t say I’m strongly in favor of a single payer system. I can find objections to it. But I still think it’s better than any other system. However, the idea of permitting private practice must not be ruled out. Similar to the U.K., there can be a single payer system which everybody can go to, and private medical practices for those who want. In the U.K., private medicine is about 20 percent of the total, so there is this escape valve for those who want it, but also a single payer system that anybody can join.

Q: Perhaps the way to fix the American health care system is simply to adopt the UK model?

I would say the Canadian model, rather than the U.K. model. But it’s so politically out of the question I don’t even think about it.

Q: So you’re saying that one answer to the influence of special interest groups in the health care system is to have the government intervene in a major way, wether it is through a single payer system or something more akin to the U.K. model?

That’s right. Of course, George Stigler would say that there could be regulatory capture, but so far it doesn’t seem to have happened really.

Q: Doesn’t the rather-muted regulatory response to phenomena like pharmaceutical price hikes and “evergreening” – making minor tweaks to existing formulations in order to artificially extend patents – suggest at least a possibility of a capture?

There’s no question that every time you have interaction between government and private interests, especially concentrated ones, they’re always going to have power. In this case, I think there’s no alternative.

Medicare particularly has succeeded in imposing price regulations of a pretty detailed nature without too much trouble. Recent regulations regarding readmission rates for Medicare have gone through a surprising lack of opposition. We know that other countries have also succeeded in doing this without too many scandals, even countries that are not thought of as models of good government.

Q: In that 1963 paper you wrote that “the laissez-faire solution for medicine isintolerable.” 50 years later, do you still believe that to be true?

We don’t have a laissez-faire system. The intervention of the federal government, as measured by expenditures, is growing. It is not a private system at all. Roughly 50 percent of health costs are paid for by the government, and state governments are spending more and more on health. It’s crowding out education. State budget-support for education, especially higher education, is crowded out by two things: health and prisons. Nobody is prepared for the idea of a laissez-faire system, and we never really had one.

Q: Together with Gérard Debreu, you revolutionized the field of economics by proving the existence of market clearing equilibrium. This has changed the field of economics, and laid the foundations for most of the advances in the field following World War II, and also for the belief that competition works to enhance welfare. However, as we know today, most markets differ quite significantly from the neoclassical model. In the meantime, we got many policies that assumed markets will produce welfare, when in many cases they did not.

My later work has dealt exactly with the second proposition. This really came out of my study of health economics. A critical issue is that the world is uncertain in many ways. From the individual’s point of view, you know you’re going to get sick, but you don’t know if medicine will save you, if medications will work. The question is, should I intervene in something that has a small chance of success? More fundamentally, in the economic system, there is uncertainty regarding what innovations will bring in the future. Some believe this can be handled by a price system – that is true, but only if everybody has the same information. You can’t make bets where one person knows the outcome and the other doesn’t. That is what I call a-symmetric information, and I argue that was a key to understanding the health economic issue.

Q: George Stigler and the public choice school predicted that regulation will inevitably be captured by special interests, and used as a tool to prevent competition. Some people see that as a reason for deregulation, or even no regulation. Perhaps we need to construct different market structures, so that regulation won’t be captured?

There’s a famous Churchill quote: “democracy is the worst form of government, except for all the others.” That applies to regulation as well. In the late 1800s, we had a natural monopoly: railroads. The government created a regulatory enterprise – the Interstate Commerce Commission – and of course it was captured. But it still made a difference.

I think we just have to accept that capture does occur, but it’s limited. The Federal Trade Commission, for example, is a pretty active body. Monopolies have been broken up. The AT&T telephone monopoly was broken up in 1982 – Stigler was still writing about regulatory capture then. AT&T was a classic monopoly, but a pretty benevolent one. It delivered good service – rates were too high, but not by that much. It didn’t necessarily pass on value to the consumers, but Bell Labs were a source of great innovative function. Nevertheless, it was broken up by antitrust measures, brought on by government.

So there is regulatory capture, but it is by no means complete. Regulations do play a role.

One example of non-regulatory capture fighting against effective regulation was during the run-up to the 2008 crash, when several officials argued for CDOs to be regulated, which means they would have had to meet certain requirements of transparency. This was not accepted. I’m not saying the crash could have been avoided if that happened, but that would have made a big difference.

Q: Regarding the financial industry, in recent years Luigi Zingales and other scholars have questioned its size. Some argue that most of its business today is in fact rent-seeking, while only half or a third of it is allocating resources efficiently. Do you agree with this sentiment?

I don’t consider myself an expert on the financial industry, but the fact that the financial industry is responsible for something like 30 percent of all profits seems rather remarkable. I am startled by the size of the financial industry and what it means. I can’t believe this is really needed for the allocation of resources. A lot of it is going to be rent-seeking. It creates a diversion of resources, especially human capital, and not only does it create problems for the legitimacy of income distribution, but that also means resources diverted for this purpose [rent-seeking] can’t be used elsewhere.

Q: There is a growing debate in recent years about the issue of “cognitive” capture, or intellectual capture. As an industry gets bigger and more concentrated, it can create an ecosystem that fosters such capture. Do you believe this type of cognitive capture can exist among economists?

I think the answer is yes. There’s no question there’s a real problem of this kind, to the extent that economists are listened to at all, which may not be very much. There were some cases where people let themselves commission analyses which served some function, like selling securities. One device that can be used against this is to require that when you publish an article, you’ll have to list any incentives you might have to form an opinion on the subject. The American Economic Association now requires this for publications in its journals.

Q: What about so-called “ideological” capture, the notion that the worldview of regulators can shape regulatory outcomes?

I think there’s no way out of that. All you can ask for is that it be clear. Any policy that has implications outside of narrow economic realms, people are bound to have feelings about it. There’s nothing illegitimate about that. The only illegitimate thing is to conceal it.

Q: A large number of industries in the U.S. today are highly concentrated. Does concentration lead to declines in innovation?

Monopolies don’t feel a need to innovate, because they’re already making money off their existing products. However, there’s an argument to be made that the incentive for innovation is the prospect for monopoly. The award for innovation is that, at least for a period of time, you have a first-mover advantage until other people catch on. Existing monopolies are bad for innovation, but the prospect of monopolies is good for innovation. That’s the paradox.

Q: Given everything that we talked about, do you think it is plausible that many (if not most) S&P 100 firms are generating some of their profits from rent-seeking, and not from creation of new value?

Certainly. I don’t think it’s true in the electronics industry, but certainly in finance and some of the older industries.

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.